EMflation

The passing of the ‘sweet spot’ in China almost had a slow inevitability about it, given its recession-defying growth performance and stimulatory policy environment. Policy focus in China now appears to have shifted rapidly from a narrow campaign to curb property speculation last year to a much broader mandate to quell inflation in 2011 (see China Economics: 2011: A Year of Reflation, November 21, 2010). Inevitably, extrapolation is rampant. Will the rest of EM go the China way? Is the sweet spot for EM growth behind us? Just as inevitably, there is no single answer for the entire EM world. Surveying our EM economics team suggests that inflation is not a universal problem in EM, nor is policy tightening likely to be severe enough to derail growth. In economies where inflation is already a concern for policy-makers, commodity prices have played a role in more cases than domestic demand-led inflation. For these countries, appropriate policy tightening is necessary and is likely to have a salutary effect on growth dynamics. In many other EM economies, however, inflation is not a problem (at least not yet). In a few cases, there is enough slack in the economy for policy-makers to focus mostly on growth for now. EM monetary policy-makers are likely to keep tightening policy, but policy rate hikes probably constitute more of a normalisation of the monetary policy stance rather than a move to an outright restrictive position.

Tapping the expertise of our EM teams: Is inflation a problem? Where it is a problem, what are the main drivers of inflation: food and/or energy prices, or domestic demand? Has the slack in the economy dwindled enough to kindle inflationary pressures? What actions will policy-makers take as part of the tightening process? These are the questions we asked our economics teams in order to understand where inflationary tensions lie and what the likely policy response is.

Is inflation a problem? The EM world appears to be split fairly evenly on this issue. Inflation is already a concern in many AXJ economies, notably in India, where the central bank has raised rates by 150bp in 2010 to ward off inflation. To a lesser extent, other AXJ economies (with the exception of Taiwan, Thailand and Malaysia) are wary of inflation and central banks have moved to take policy rates off the low levels that were in place during the Great Recession. The exception to this rule is Indonesia, where inflation risk is moderate but relatively higher than the rest of the AXJ region. Outside the AXJ region, the economies of Brazil and Peru in Latin America and Poland, Hungary and Romania in the CEEMEA region are grappling with an inflation problem as well.

Our China economics team expects inflation to become the macro focus in 2011 because of cyclical as well as structural factors (see again China Economics: 2011: A Year of Reflation). Cyclically, the lagged effects of ultra-expansionary monetary policy are expected to drive inflation higher. Structurally, the shift in production from the tradable to the non-tradable sector will lower overall productivity, leading to higher inflation. Policy-makers will be keen to push inflation expectations lower, possibly through a combination of some constraints on domestic credit expansion and/or constraints on money growth, some currency appreciation and policy rate hikes.

In other EM economies, inflation is not an immediate problem: In some cases, overall inflation is not high and the metric that matters for policy-makers, core inflation, has remained well behaved (e.g., in Malaysia and Thailand). In other economies like Mexico, Russia and the UAE, the slack in the economy is large enough that the risk of inflation rising sharply seems to be a small one.

Where inflation is a problem, what are its main drivers? Inflation being a concern for policy-makers is a necessary but not a sufficient concern for an aggressive tightening of policy. It is very important to identify the drivers of inflation. Is inflation driven by food or energy or other commodity prices? Or is stronger domestic demand responsible for inflation concerns? If it is the former, policy reaction is likely to be muted. However, central banks will be more likely to take action to quell domestic demand if it is pushing inflation higher.

Food and energy inflation as drivers of inflation: If headline numbers are driven by internationally traded commodity prices, EM central banks are likely to adopt an approach similar to the one they had in 2007. Then, EM central banks resisted tightening as international commodity prices were driven by strong global demand and central banks were individually incapable of lowering international prices through tighter monetary policy. Clearly, collective action would have helped, but the difficulties of creating such a like-minded group and the difficulties of sustaining commitment in this monetary policy cartel would have proved formidable – and this when growth was exceptionally strong globally without a strong hint of the oncoming global recession. Today, a similar consensus appears to exist among EM central bankers, but for very different reasons. EM economies now appear to be growing sustainably, providing a bid for food, energy and other commodity prices. At the same time, ultra-loose monetary policies from the major central banks have pumped enough liquidity into the system to drive up asset and commodity prices. Getting EM central banks to collectively hike rates by enough to offset liquidity injections from the major central banks appears to be close to impossible, given that this would almost certainly put domestic growth in the EM economies in question at risk.

And indeed, food inflation appears to be the main driver (or the joint main driver) of inflation in a large number of EM economies. The big risk, naturally, is one of second-round effects of food price inflation on core inflation. This is particularly true where food inflation is high, domestic demand is strong but domestic demand-led core inflation has not yet picked up. The ideal example in this category is Indonesia, where food inflation has been a problem for a while and where domestic demand has been strong as well. The risk of a pass-through from food to more general inflation is therefore a worry. Turkey shares similar concerns but food prices are expected to normalise there, cutting down the risk of a pass-through into more general inflation.

Domestic demand-led inflation: In a handful of economies (Brazil, Indonesia, Israel, South Africa and Saudi Arabia), however, domestic demand-led inflation is the most important concern (though Israel really has only a housing price inflation worry). Of these economies, Indonesia has been pointed out as the economy that has moderate risk both from domestic demand pressures as well as the risk of pass-through from food prices to overall inflation. Brazil and Israel have both used rate hikes so far, partly to address inflation concerns. Both central banks are expected to further raise policy rates in order to bring inflation under control as needed.

Is slack so little now that inflation is likely to be a problem in the near future? A surprisingly large number of economies report that economic slack is still present, but that the output gap is not very wide.

In some economies, the output gap is closed, indicating that a continuation of rapid growth may start putting upward pressure on inflation going forward. In some cases, the output gap is still negative and quite large. Prominent in this category is the Russian economy, where the output gap has narrowed but still remains quite large. It is not surprising, then, to note that Russian policy-makers appear to be giving much more support to pro-growth policies than to anti-inflation ones. The South African economy is the other economy where the output gap is large enough for policy-makers to ignore inflation concerns for the moment. Two rate cuts of 50bp each recently delivered by the SARB provide strong evidence of this.

What is the policy response likely to be? In light of the above, it may appear somewhat surprising, at first blush, to note that monetary tightening seems to be almost universal in the EM universe that we cover. However, monetary tightening becomes easier to understand when we differentiate between normalisation of rates and moving to an outright restrictive monetary policy stance. Many of the policy rate hikes, particularly in the case where the output gap is still negative and inflation is not a problem, represent normalisation of policy to a stance that is a little less expansionary. Even in the economies where inflation is a problem and the output gap has either closed or is very narrow, we don’t expect policy rates to be hiked to an extent where they will begin to hurt growth. Even for the outperforming AXJ economies, policy tightening is likely to be calibrated to just keep growth from rising further rather than pushing it lower. Policy actions are thus unlikely to derail growth in the EM economies.

Constrained by the trilemma: Even if monetary policy-makers wanted to be aggressive, they would be bound by the constraints of the trilemma (monetary policy-makers can achieve only two out of the trinity of unconstrained capital flows, a stable exchange rate and independent monetary policy).

At a time when capital inflows into EM economies have been aggravated by the Fed’s QE2 salvo, avoiding currency appreciation will severely limit the amount of monetary tightening central banks can attempt. Of course, central banks may choose to break the flow of capital into the domestic economy through the use of capital controls, but to do that, they would have to rival the extensive controls that China has in place. In our view, the kind of capital controls we have seen so far (taxes on capital inflows into domestic fixed income markets) are more likely to change the composition of inflows towards equity flows, but not change the overall level of capital inflows.

Which monetary policy tools? Contrary to their developed market peers, EM central bankers are not reluctant to use the many tools at their disposal, including policy rates, the exchange rate, liquidity constraints, capital controls and even strong moral suasion to banks regarding lending activities. Focusing on a narrow set of tools, however, interest rates and exchange rates appear to be heading higher going forward, except for India, Thailand, Hungary and Brazil, where there appears to be limited scope for further currency appreciation. In many cases, policy-makers may prefer to have less currency appreciation but may not be successful in warding off capital inflows and the resulting upward pressure on their currency. In any event, EM economies appear to be set for a gradual appreciation of their currencies, probably thanks to a combination of tighter monetary policy and steady capital inflows in line with the constraints of the trilemma.

In summary: The policy response to inflation in overheating economies is likely to lead to a salutary slowdown in these economies rather than a hard landing. Where inflation is not a problem, policy rates may be hiked, but this will likely be more for the purposes of normalisation of policy rates than for creating a restrictive monetary policy stance. If successful, these dual strategies should allow solid growth to persist in the EM world. The key risk remains that the combination of relatively easy domestic monetary policy in EM countries and even more easy money imported from the leading economies will push inflation higher. The policy response then would have to be stronger if EM central banks wish to protect medium-term growth by keeping inflation under control.